Commercial Banking Chapter 1
What are five areas of institution-specific FI specialness and which types of institutions are most likely to be the service providers?
1.)commercial banks and other depository institutions are key players for the transmission of monetary policy from the central bank to the rest of the economy. 2) specific FIs often are identified as the major source of financing for certain sectors of the economy. For example, savings institutions traditionally serve the credit needs of the residential real estate market. 3) life insurance companies and pension funds commonly are encouraged to provide mechanisms to transfer wealth across generations. 4) depository institutions efficiently provide payment services to benefit the economy. 5) money market and debt-equity mutual funds provide denomination intermediation by allowing small investors to purchase pieces of assets with large minimum sizes such as negotiable CDs and commercial paper issues.
What are the tools used by the Federal Reserve to implement monetary policy?
-open market operations: the Federal Reserve's purchases or sales of securities in the US Treasury securities market -discount rate: the rate of interest Federal Reserve Banks charge on "emergency" or "lender of last resort" loans to depository institutions in their district -reserve requirements: determine minimum amount of reserve assets the depository insinuations must maintain by law to back transaction deposits held as liabilities on their balance sheet
What forms of protection and regulation do regulators of FIs impose to ensure their safety and soundness?
1) required to diversify assets. legal lending limit to each borrower 2) required to maintain minimum amounts of capital to cushion any unexpected losses 3) regulators have set up guaranty funds such as DIF for commercial banks, SIPC for securities firms, and state guaranty funds for insurance firms to protect individual investors 4)Regulators also engage in periodic monitoring and surveillance, such as on-site examinations, and request periodic information from the FIs.
What are five general areas of FI specialness that are caused by providing various services to sectors of the economy?
1. FIs collect and process information more efficiently than individual savers 2. provide secondary claims to household savers which often have better liquidity characteristics that primary securities such as equities and bonds 3. by diversifying the asset base FIs provide secondary securities with lower price risk conditions than primary securities 4. provide economies of scale in transaction costs because assets are purchased in larger amounts 5. provide maturity intermediation to the economy which allows the introduction of additional types of investment contracts
What are two of the most important payment services provided by financial institutions? To what extent do these services efficiently provide benefits to the economy?
1. check clearing 2. wire transfer services any breakdown would produce gridlock in the payment system resulting in harmful effects to the economy
What are five risks common to all financial institutions?
1. default or credit risk of assets 2. interest rate risk caused by maturity mismatches between assets and liabilities 3. liability withdrawal or liquidity risk 4. underwriting risk 5. operating risks
What is negative externality? In what ways do the existence of negative externalities justify the extra regulatory attention received by financial institutions?
A negative externality refers to the action by one party that has an adverse effect on another party who is not part of the original transaction. FI's are regulated to prevent the costs to sources (households) and users (firms) of savings if a breakdown in services happen
How can financial institutions invest in high-risk assets with funding provided by low-risk liabilities from savers?
FI's exploit the law of large numbers in investments, achieving a significant amount of diversification, whereas because of their small size, many household savers are constrained to holding relatively undiversified portfolios diversification and law of large numbers
In what sense are the financial claims of FIs considered secondary securities, while the financial claims of commercial corporations are considered primary securities? How does the transformation process, or intermediation, reduce the risk, or economic disincentives, to the savers?
Funds raised by the financial claims issued by commercial corporations are used to invest in real assets. These financial claims, which are considered primary securities, are purchased by FIs whose financial claims therefore are considered secondary securities. Savers who invest in the financial claims of FIs are indirectly investing in the primary securities of commercial corporations. However, the information gathering and evaluation expenses, monitoring expenses, liquidity costs, and price risk of placing the investments directly with the commercial corporation are reduced because of the efficiencies of the FI.
What is maturity intermediation? What are some of the ways in which the risks of maturity intermediation are managed by financial institutions?
If net borrowers and net lenders have different optimal time horizons, FIs can service both sectors by matching their asset and liability maturities through on- and off-balance sheet hedging activities and flexible access to the financial markets. By investing in a portfolio of long- and short-term assets that have variable- and fixed-rate components, the FI can reduce maturity risk exposure by utilizing liabilities that have similar variable- and fixed-rate characteristics, or by using futures, options, swaps, and other derivative products. banks take short term deposits and make long term loans
What events resulted in banks' shift from the traditional banking model of "originate and hold" to a model of "originate and distribute?"
activities of shadow banks, nonfinancial service firms that perform banking services, have facilitated the change from the originate and hold model of commercial banking to the originate and distribute banking model. the traditional model exposes the institution to potential liquidity, interest rate, and credit risk if they kept the loan, then they cared
What are agency costs? How do FIs solve the information and related agency costs experienced when household savers invest directly in securities issued by corporations
agency costs occur when owners or managers take actions that are not in the best interests of the equity investor or lender FI has greater incentive to collect info and monitor the activities of the borrower because it has far more at stake that does any small individual household
Why are FIs among the most regulated sectors in the world? When is the net regulatory burden positive?
because they provide sources of financing that fund economic growth opportunities and transaction services to the economy that facilitate trade and wealth accumulation. distressed FIs create negative externalities for the entire economy that affect more than just shareholders and other claimants on the FIs assets. net regulatory burden: the need for regulation to minimize social costs may impose private costs to the FIs that would not exist without regulation To the extent that these additional costs help to avoid negative externalities and to ensure smooth and efficient operation of the economy, the net regulatory burden is positive
Identify and explain the two functions FIs perform that would enable the smooth flow of funds from household savers to corporate users.
by providing a brokerage function and by engaging in an asset transformation function may provide only transaction services such as discount brokerages, or they may also offer advisory services which help reduce information costs. the asset transformation function is accomplished by issuing their own securities, such as deposits and insurance policies that are more attractive to household savers, and using the proceeds to purchase the primary securities of corporations
How do financial institutions help individual savers diversify their portfolio risks? Which type of financial institution is best able to achieve this goal?
money placed in any financial institution will result in a claim on a more diversified portfolio as long as the returns on different investments are not perfectly positively correlated by exploiting the benefits of size, FIs diversify away significant amounts of portfolio risk Best able to achieve: banks that lend money to many different types of corporate, consumer, and government customers. Investments in a mutual fund may generate the greatest diversification benefit.
what is shadow banking
takes peoples money and invests it, mostly in the form of loans. acts like banks but are not banks
How do regulations regarding barriers to entry and the scope of permitted activities affect the charter value of financial institutions?
the profitability of existing firms will be increased as the direct and indirect costs of establishing competition increase. As these barriers to entry are stronger, the charter value for existing firms is higher.
